Wednesday, June 26, 2013

Life is Better on the (Tech) Edge

I had the chance to catch up with Bernstein's IT analyst Toni Sacconaghi yesterday.

Toni has been following the IT space for almost 14 years for Bernstein, and is one of the best on the Street.  His universe of coverage is relatively small - only six names - but they include technology bellwethers like Apple, EMC and IBM.

Large cap tech names mostly trade at very low multiples.  Based on Toni's estimates, all of the tech names he follows are trading at discounts to the S&P 500:

Apple                9.5x
 Dell                 12.0x
 EMC                11.7x
HP                     6.5x
IBM                  11.2x
Lexmark              8.3x

S&P 500          13.5x

So the obvious question:  Should portfolios be loading up on these stocks?

The answer is not as plain as you might expect.

Yes, Toni agrees that these stocks are cheap, but they might be for a reason.

Spending on technology has slowed dramatically from the pace of the last couple of decades.  Toni is predicting that spending on tech hardware will be only slightly ahead of the pace of 2012 - up +2%.  Compare to the high teens growth rates of the late 1990's, or high single digits just a few years ago, the tech space is a different world than it had been in the past.

The tech space has become somewhat bifurcated. There are the large stocks that Toni follows, which trade a low multiples suggesting that their best growth days are behind them.

Then there is the high flying, rapidly growing technology names whose business is growing at +50% to +100% per year. These would be names like LinkedIn (100x 2014 earnings estimates) or WorkDay (36x sales).  Investors are willing to pay up for these stocks since they represent the future - maybe.

There are, of course, a huge number of technology names that fall somewhere in between the big stalwarts and the high-fliers.  These still trade at a modest premium to the market, but have better growth rates as well.

Bernstein suggests a barbell approach to the technology sector, and has the data to back up their insights.

Historically, it seems, that the best way to invest in technology stocks is to invest on the edges, and ignore the middle. Bernstein advocates a portfolio combining stocks with the highest growth profiles (and loftiest valuation) and stocks with the slowest growth potential (and cheapest valuation), and ignoring the 60% of the tech stocks that do not fit either criteria.

Based on results going back to December 1977, a barbell approach combining highest + lowest valuation tech stocks has robustly outperformed a middle-of -the-road approach.

In other words, in tech land, living life on the edge(s) is the way to go.